Effective Hedging Under IAS 39
Jeffrey B. Wallace
Executive Summary
After a review of the general IAS 39 effectiveness
testing rules, including critical terms, this article
discusses how to achieve hedge accounting for
these common corporate hedges:
1. Interest rate swaps (IRS).
2. Cross-currency interest rate swaps (CCIRS).
3. Forecast interco flows.
4. Foreign currency interco loans.
5. Netting of offsetting cash flow exposures.
6. Options.
General Effectiveness Testing Rules
IAS 39.AG105 requires that any hedges at
inception must be expected to almost fully offset
changes in expected cash flows or fair value of
the hedged item. As explained in IAS 39.BC136
and the Guidance on Implementing IAS 39 (IG)
F.4.6, deliberate underhedging of the exposure, a
FAS 133 technique that can minimize reported
ineffectiveness, is disallowed in IAS 39. As with
FAS 133, the prospective expectation that the
hedge will almost fully offset the hedged item
can be justified in any number of ways, inclu-
ding statistical testing, as described at IG F.4.4.
IAS 39.AG108 does state that if the critical
terms of the hedge instrument and the hedged
item are the same, then the hedging relationship
is likely to be an effective hedge. This is also re-
peated in IAS 39.BC35, which states the Board’s
opinion that in many cases no ineffectiveness
would be recognized for a single currency IRS
whose critical terms match the hedged item’s.
Thus, critical terms can be used to justify the
prospective expectation that the hedge will almost
fully offset the hedged item.
However, unlike FAS 133, if critical terms
are the same, one still has to do the retrospective
effectiveness test. IAS 39.AG105 requires that all
hedges must do retrospective testing using the
dollar offset ratio method and fall between 80-
125%. This is more stringent than FAS 133,
which also allows retrospective statistical
methods. It seems that the Board feels that
testing is necessary due risk of adverse counter-
© 2004 by Greenwich Treasury Advisors LLC. All rights reserved worldwide.
Managing Partner
Greenwich Treasury Advisors
party credit changes, which could affect the
change in the hedge instrument’s fair value.
Of course, in the common situation where
critical terms remain the same with no counter-
party credit deterioration, then the hedge will be
100% effective when the dollar offset ratio is
calculated.
Swap Hedging
IAS 39.76 explicitly allows CCIRS hedging, with
an example given in IG F.1.12. However, FAS
133’s shortcut treatment for perfect single
currency IRS was considered by the Board in IAS
39.BC132-135 and rejected.
This is not really a problem because IG F.5.5
shows the use of the hypothetical derivative
method for effectiveness testing. Thus, as with
FAS 133, one can justify documenting effective-
ness tests in which the changes in the fair value
of the hedge item are modeled as if the hedged
item were a hypothetical derivative perfectly
matching the terms of the hedged item. Then,
this proxy calculation is used with the changes in
the fair value of the actual hedging instrument in
calculating the retrospective dollar offset ratio
test and any P&L ineffectiveness.
Putting everything together, perfect cash
flow or fair value IRS hedging of debt or invest-
ments can be justified as highly effective on a
prospective basis because critical terms are the
same. Retrospective testing is done in the usual
way by calculating the ratio of the change in the
fair value of the hedging swap with the change in
the fair value of a hypothetical perfect swap
modeling the hedged item.
Since the terms of the real swap and the
hypothetical swap exactly offset each other by
definition, the dollar offset ratio is 100% and
there is no ineffectiveness. Please note that this
hypothetical derivative methodology can also be
used for effectiveness testing of imperfect IRS
and, as we will see, imperfect CCIRS hedges.
May 6, 2004
Page 2
Similarly, the hypothetical derivative
method can also be used to show 100% effective-
ness for perfect CCIRS hedging from of external
debt or investments from fixed to fixed or
floating to fixed.
As with FAS 133, if one desires to go from
floating loan to floating loan, one should do a
floating-to-floating swap, but not designate it as
hedge instrument. The mark-to-market on an
AA-rated floating-to-floating swap will only have
small valuation around zero due to interest rate
changes, but will have an FX change in value
sufficient to offset the IAS 21 spot-to-spot
revaluation on the foreign currency loan. The
net P&L impact of both items should be
acceptably small.
As we will discuss in more detail below,
these same CCIRS hedging rules will also apply
to hedging foreign entity interco loans.
Hedging Foreign Entity Interco Flows
Hedging interco flows under IAS 39 requires an
understanding of IAS 21, The Effects of Changes
in Foreign Exchange Rates. IAS 21 is the coun-
terpart to FAS 52, describing how foreign unit
financial statements are consolidated with the
parent results into the parent reporting currency.
Unlike FAS 52, IAS 21 distinguishes between
foreign subs that are “integral to the operations
of the reporting enterprise” and those that are
“foreign entities.” IAS 39 uses this categorization
to allow hedging of only foreign entity interco
FX exposures.
Per IAS 21.23, “A foreign operation that is
integral to the operations of the reporting en-
terprise carries on its business as if it were an
extension of the reporting enterprise’s
operations.”
In such cases, IAS 21.27 requires that “The
financial statements of the foreign operation ...
should be translated … as if all its transactions
had been entered into by the reporting
enterprise itself,” i.e., its functional currency is
the parent’s reporting currency.
A foreign entity, as described in IAS 21.27,
“… accumulates cash and other monetary items,
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incurs expenses, generates income and perhaps
arranges borrowings, all substantially in its local
currency… the change in the exchange rate
affects the reporting enterprise’s net investment
in the foreign entity rather than the individual
monetary and non-monetary items held by the
foreign entity.” Here, the consolidated
accounting is identical to FAS 52 in which the
functional currency is the local currency.
IAS 21.26 lists five factors for classifying
foreign subs. A pure importer of parent products
would be integral. A pure local sub with 100%
local revenues and costs would be a foreign
entity. However, a large manufacturing and
importing foreign sub would be a foreign entity.
Regarding interco hedging, IAS 39.80 is
inadvertently ambiguous:
“As an exception, the foreign currency
risk of an intragroup monetary item (eg a
payable/receivable between two sub-
sidiaries) may qualify as a hedged item in
the consolidated financial statements if
it results in an exposure to foreign
exchange rate gains or losses that are not
fully eliminated in consolidation under
IAS 21 …” [author’s emphasis]
This happens between two subs qualifying as
foreign entities. The text appears to allow hed-
ging of only recognized intragroup monetary
items, not forecast items. However, the clear
intent of the Board is that all FX risks associated
with such kinds of interco monetary items are
hedgeable, including forecasted interco sales,
purchases, interest, fees, etc., allowing cash flow
hedge accounting. The Board may clarify their
intent in the next several months.
Thus, if a foreign subsidiary is a foreign
entity, then IAS 39.80 does allow hedging of
forecast interco flows, just as FAS 133 does.
However, if the foreign sub is an integral or
branch operation under IAS 21, then forecast
interco flows are not hedgeable. In this case, then
all of the external foreign currency flows of the
integral sub are hedgeable in accordance with the
usual rules, just as if the sub’s foreign currency
flows were actual flows of the parent.
Page 3
Hedging Interco Loans
IAS 39 is unequivocal that the interest rate risk
of an interco loan is not a hedgeable item. If a
Central Treasury wants to lend floating and use
an interest rate swap to achieve the economic
impact of fixed rate debt, then Central Treasury
must identify a suitable external debt to receive
hedge accounting on the swap. Please note that
there are numerous discussions in IAS 39 and in
the IG questions showing acceptable techniques
for effectively hedging various kinds of intra-
group interest rate risk.
As discussed, for foreign entities per IAS 21,
IAS 39.80 allows foreign currency intragroup
monetary items as eligible FX risk hedge items.
Thus, any cross-currency interest rate swap on
an interco monetary item must be used as a pure
FX hedge, not as a mixed FX and interest rate
hedge (see IG F.1.12.).
As discussed with CCIRS hedges of external
items, one could achieve a fixed rate interco
loan by lending a fixed rate interco loan in one
currency and swapping with a fixed-fixed CCIRS
into another currency or by lending an interco
floating in one currency and swapping into fixed
currency in another currency. Floating-to-
floating is best done by accepting the net mark-
to-market on the swap and the interco item
without hedge accounting.
Netting Offsetting FX Cash Flow Exposures
Unlike FAS 133, IAS 39 does not allow the net-
ting of eligible offsetting cash flow exposures
with internal contracts. However, IG F.1.4, IG
F.1.5 and IG F.1.6 show how netting can be
effectively achieved with some additional work.
First, any entity in the group can hedge, on
an after-tax basis if desired, any other group
entity’s FX, interest rate, commodity or credit
risk. Parenthetically, this is a very useful
difference from FAS 133.
Second, while hedge accounting for internal
contracts is not allowed for the consolidated
reports, it is allowed for individual unit financial
statements and for segment reporting of the
consolidated group. However, if done, the
hedging entries must be reversed in the final
consolidation.
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With suitable documentation, a foreign unit
can receive hedge accounting for an internal for-
ward with a treasury center (TC) for the foreign
unit’s own financials. The TC executes an off-
setting external contract, and also documents it
as a hedge of the foreign unit’s exposure. Then,
the group will receive hedge accounting at the
consolidated level. If hedge accounting is not
needed at the foreign unit level or for segment
reporting, then only the TC’s hedge document-
ation is needed.
As IG F.1.6 describes in some detail, one can
achieve the effect of netting offsetting exposures
by doing internal contracts and then designating
the net residual as a hedge of the larger exposure.
For example, Sub A and B are euro functional
entities, and Sub A forecasts $500 in dollar reve-
nues and B forecasts $300 in dollar expenses.
Both do internal contracts with a TC and both
do the documentation qualifying for hedge
accounting on their own stand-alone financials.
The TC sells $200 forward with an external party
and documents this as an IAS 39 cash flow
exposure of A’s first $200 in forecast revenue.
A perhaps easier solution is to have the bank
write two simultaneous contracts with the TC,
one selling $500 and the other buying $300, and
use both as separate IAS 39 cash flow hedges for
Subs A and B, where both will receive hedge
accounting at the consolidated level. This “gross
basis” hedging is approved in IG F2.15.
Option Hedging
Neither IAS 39 nor the IG explicitly allow FAS
133’s G20’s 100% effectiveness for perfect Euro-
pean option hedging. IAS 39 does discuss how
option hedges can be effective by excluding the
option’s time value, which will result in
unpredictable and often unacceptable P&L
volatility since excluded time value goes directly
to P&L.
However, IAS 39 specifically does not
require any single effectiveness test for any
particular hedging instrument. In my opinion,
sound theoretical arguments can be made to
justify 100% effectiveness with perfect European
option hedges using the hypothetical derivative
effective method.
Page 4
Conclusions
This short paper is not intended to be an
exhaustive description of hedging under IAS 39.
For example, it does not discuss interest rate
portfolio hedging, which has new rules issued in
March 2004. Nor does it focus on other dif-
ferences between IAS 39 and FAS 133, e.g., the
acceptable use under IAS 39, subject to certain
restrictions, of balance sheet exposures as
hedging instruments in cash flow hedging,
something that is not allowed under FAS 133.
FAS 133 provides for a 60 day “grace period” for
forecast error, which is not mentioned anywhere
in IAS 39 or the IG, but probably will be accep-
table to most auditors for IAS 39.
In my opinion, for common corporate (i.e.,
non-financial institution) hedging, nearly all
reasonable, non-exotic hedges that are effective
under FAS 133 will be effective under IAS 39,
and vice versa. How one may document these
hedges may differ under the two GAAPs, and
there may be additional work involved in that
documentation, but the IASB has done an ad-
mirable job in developing a readable standard
that in many ways is more flexible and more
reasonable than FAS 133, and generates nearly
the same results.
Any person wishing to become more know-
ledgeable about IAS 39 hedger is advised to order
the “FAS 133 Green Book” from the FASB. This
850 page book is the current version of FAS 133
with all amendments, and includes over 175
“DIG Issues,” which answer common questions
about how to implement FAS 133. Many of these
DIG Issues provide substantial insight and, per-
haps, authoritative guidance acceptable to your
auditors, for implementing IAS 39.
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About the Author
Jeff Wallace is Managing Director of Greenwich
Treasury Advisors LLC, a Greenwich, CT USA
treasury consulting firm that he founded in
1992. He is the author of the FAS 133 chapter in
the International Finance and Accounting Hand-
book (2003, John Wiley & Sons) as well as of The
Group of 31 Report: Core Principles for Managing
Multinational Foreign Exchange Risk (1999,
Association for Finance Professionals). These
and other useful treasury articles may be
downloaded at:
www.greenwichtreasury.com/articles/.
His corporate experience includes being Vice
President – International Treasury at American
Express, and was Assistant Treasurer at both
Seagram and Dun & Bradstreet. Jeff was also a
CPA at Price Waterhouse.
For more information on the firm’s expertise in
developing GAAP-effective hedging strategies for
US, International and Canadian GAAP, visit:
www.greenwichtreasury.com/services/gaap/.
Jeff‘s email address is:
jeff.wallace@greenwichtreasury.com.
Greenwich Treasury Advisors has just
announced that it has agreed to merge with
Treasury Alliance LLC, where Jeff Wallace will
be a partner. Jeff may be also reached at
jeff.wallace@treasuryalliance.com.